Harvard Business School alumni lecture

In Today’s China, Paradoxes Still Abound. But So Do Opportunities — Site Selection Magazine

 

In September, China First Capital Chairman and CEO Peter Fuhrman, familiar to attendees at the World Forum for FDI in Shanghai last year, delivered a talk from China to Harvard Business School alumni. Here, with Mr. Fuhrman’s permission, we present excerpts from his remarks.

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GDP growth has never and will never absolutely correlate with investment returns.

Any questions? No? Great. Thanks for your time.

Of course I’m joking. But that key reality of successful investing is all too often overlooked, and China has provided all of us over these last 30-some-odd years with a vivid reminder that IRR and GDP are by no means the same animal.

China is, was and will likely long remain a phenomenal economy. The growth that’s taken place here since I first set foot in China in 1981 has been something almost beyond human reckoning. Since I first came to China as a postgrad in 1981, per-capita GDP (PPP) has risen 43X, from $352 to $15,417. China achieved so much more than anyone dare hope, a billion people lifted out of poverty, freed to pursue their dreams, to make and spend a bundle.

China this year will add about $1 trillion of new GDP. Just to put that in context, $1 trillion is not a lot less than the entire GDP of Russia. So who is making all this newly minted money? And how can any of us hope to get a piece of it? Another question: Why, if China is such a great economy, has it proved such a disaster area for so many of the world’s largest, most sophisticated global institutional investors, private equity firms and Fortune 500s?

Turning Inward

Let’s start with the fact that China is a part of the World Trade Organization, but not entirely of it — not fully subscribed in any way to the notion that reciprocity, openness, free trade, level playing fields and equal treatment are positive ends unto themselves. As China has gotten richer it has seen even less and less need to attract foreign capital and foreign investment. That’s a tendency we see in other countries, including obviously some of the rhetoric we now hear in the U.S. — that more of the gains of the national economy should belong to its citizens. But China’s way is different.

The renminbi is a closed non-tradable currency, so getting US dollars into and out of China has always been difficult. China now has the world’s second-largest stock and bond markets, but those markets are largely closed to any investors other than Chinese domestic ones. But China also continues to provide companies going public with by far the highest multiples anywhere in the world.

When I first came to China 36 years ago China was a 100-percent state-owned economy. Twenty years ago the first rules were put in place to allow a private sector to function. Today, according to anyone’s best estimate, it’s about 70 percent private and 30 percent state, and most of the value creation is being provided by that private-sector economy. So in theory there should be very interesting M&A opportunities. But it’s been exceedingly difficult to get successful transactions done. One of the core reasons is that by and large all private-sector companies in China, large and small, are family-owned.

The other thing important to consider is a Mandarin term: guifan. It’s the Chinese way of explaining the extent to which a company in China is abiding by all the rules of the road — the taxes you should pay, the environmental and labor laws you should follow. It’s not at all uncommon that successful private-sector companies in China are successful by virtue of having negotiated to pay little or no corporate tax on profits.

For foreign-owned companies in China it’s an entirely different story. They are by and large 100-percent compliant with the written rules. This has an enormous impact on the operating performance of any company, so you can imagine how potentially skewed the competitive environment becomes. And keep in mind that corporate taxation in China in the aggregate is, if not the highest in the developed world, then among the highest, and the environmental and labor laws are every bit as difficult, rigorous, tough and expensive to implement as they are in the U.S.

China is a country where local government officials are scored on the measurable success of their time in office, and success is overwhelmingly attributed to GDP growth. So it should be no surprise if what they’re trying to do is optimize GDP growth, the percentage of a company’s income that goes back to the government in taxation can have an adverse effect on that. Instead the government will continue to urge its local companies to take the money and, rather than pay tax, continue to invest, expand and therefore build local GDP.

The Hum of Consumerism

The reasons to stay engaged and find a viable investment angle include GDP growth. China’s GDP is likely to continue to grow by at least 6 percent a year. Second, across my 25 years of involvement in China, every one of the predictions of imminent collapse — financial catastrophe, local government debt, bad bank loans, real estate bubbles — have proved to be false. It appears China has some resiliency, and it’s certainly the case that the government has the tools and financial resources to ride out most challenges.

Third has been how effortlessly it’s made the transition that still bedevils lots of Europe, from a smokestack economy to a consumer-spending paradise. At this moment every major consumer market in China is booming both online and offline. Alibaba, Baidu and Tencent are now operating as three of the most profitable companies in the world.

How does China have a robust, booming consumer economy and an enormous appetite for luxury brands, yet on average salary levels that are still one-fifth or one-sixth the levels in the US? The simple answer is that almost all the Chinese now living in urban China — about half the population, compared to about 15 percent when I first got here — owns at least a single apartment if not multiple, which is more and more common. The single best-performing asset in history has probably been Chinese urban real estate over the last 30 years. It’s fair to say the average appreciation over the last 10 years is at least 300 percent.

Though China has a population whose incomes on paper look like those of people flipping burgers at McDonald’s, they seem to have the spending power and love of luxury goods like the people summering in East Hampton. Even Apple itself has no idea how big its market is here in China. It’s likely that at least 100 million iPhone 8s will be sold to Chinese over the next year. The retail price here in China is at least 30 to 40 percent higher than in the US, with most phones bought for cash, without a carrier subsidy.

‘You’ll Be Older Too’

So where is it possible to make money in China? One message above all: Active investing beats passive investing every time. What you need to do is either be the owner-operator or be a close strategic partner with one, and stay actively engaged.

There are four major areas of opportunity: Tech, health-care services, leisure and education (see graphic below). The potential for building out a chronic care business in China is enormous. Looking ahead 25 to 30 years, sadly China will likely suffer a demographic disaster. This country will become a very old society very quickly. That’s the inevitable product of 30 years of a one-child-per-family policy. By 2040 or 2050, 25 percent of China will be over the age of 65.

The overall rate of GDP growth is unlikely to ever rival that of a few years ago at 10 to 12 percent a year, but overall what we have is higher-quality growth. People in China are living well. Things should continue to motor along very smoothly at least for one more generation — a generation whose members are better educated, more skilled, ambitious and globalized than their parents.

There’s no denying the reality of what a better, happier, freer, richer country China has become since I first set foot here. I marvel every day at the China that I now live in, even while I occasionally curse some of the unwanted byproducts like heavy pollution in most parts of the country, overcrowding at tourist attractions, bad traffic, and a pushy culture that’s lost touch with some of China’s ancient glories.

China will continue to amaze, inspire and stupefy the world. The Chinese have done very well and will do better. At the same time, those of us investing in China may do a little better in years to come than we have up to now. More of the newly minted trillions in China just may end up sticking to our palms.

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China Investing, The Pain and the Perks — Harvard Business School Global Alumni Lecture

 

It was a delight and a privilege to give a talk on China investing to Harvard Business School’s global alumni organization. If you’d like to see the slide deck, please click here. The audio version of the lecture, done by worldwide webcast,  is also up on YouTube.

The topic was a big one — why have China investment returns so often failed to keep pace with the phenomenal growth in the country’s economy, and can investors do anything to improve the odds of success? Given an hour to discuss, I could only really scratch the surface.

A key takeaway: the past needn’t be prologue. Investing in China may prove less vexatious in the future. In part, that’s because of the growth of a mass affluent consumer market in China, a shift that plays to the strengths of many US, European and East Asian companies and institutional investors. Second, of course, everyone now can learn from past mistakes and misperceptions.

As I said in closing, “China will continue to amaze, inspire and stupefy the world. Chinese have done very well and will do better. At same time, those of us investing in China may do a little better here in years to come than we have up to now. More of the newly minted trillions in China just may end up sticking to our palms.”

 

 

 

Why Has China’s GDP So Outpaced IRR?

It’s the paradox at the core of China investing: why has such a phenomenal economy proved such a disappointing investment destination for so many global institutional investors, PE firms and Fortune 500s.

Financial theory provides a conceptual explanation. Investment returns are not absolutely correlated to GDP growth. China will likely go down in history as the best proof of this theorem. China as certainly delivered exceptional GDP growth. In per capita PPP terms, China is 43 times larger than in 1981, when I first set foot in China as a grad student. No other country has ever grown so fast, for so long and lifted so many people out of poverty and into the consumer middle class.

Commensurate investment returns, however, have been far harder to lock in. Harvard Business School’s global alumni organization invited me to give an hour-long talk on this topic this week. It required a quick gallop through some recent and not always happy history to arrive at the key question — does the future hold m0re promise for global institutional investors looking to deploy capital in China.

 For more detailed look at some reasons for the big disconnect between China’s national GPD growth and investment IRR, and some suggestions how to improve matters, please have a look by clicking here at the HBS talk slide deck.

Publicly-quoted shares in Chinese companies have failed by far and away to keep pace with the growth in overall national income. In the alternative investment arena, global PE and VC firms enjoyed some huge early success in late 1990s and first part of the 2000s. Since then, the situation has worsened, as measured in cash returns paid out to Limited Partners. One major reason — the explosion within China of Renminbi investment funds, now numbering at least 1,000. They’ve bid up valuations, gotten first access to better opportunities, and left the major global PE and VC firms often sitting on the sidelines. With tens of billions in dry powder, these global firms look more and more like deposed financial royalty — rich, nostalgic, melancholy and idle.

China this year will add approximately $1 trillion of new gdp this year – that’s not a lot less than the entire gdp of Russia. Indeed, China gdp growth in 2017 is larger than the entire gdp of all but 15 countries. Who is making all this money? Are all the spoils reserved for local investors and entrepreneurs? Can global investors find a way at last to get a bigger piece of all this new wealth?

Overall, I’m moderately sanguine that lessons have been learned, especially about the large risks of following the Renminbi fund herd into what are meant to be sure-thing “Pre-Ipo” minority deals. Active investment strategies have generally done better. With China’s economy well along in its high-speed transition away from smokestack industries and OEM exports to one powered by consumer spending, there are new, larger and ripe opportunities for global investors. In virtually all major, growing categories of consumer spending, Western brands are doing well, and will likely do better, as Chinese consumers preferences move upmarket to embrace high-quality, well-established global household brand names.

Harvard, its alumni and benefactors have a two hundred year history of investing and operating in China. So, there’s some deep institutional memory and fascination, not least with the risks and moral quandaries that come with the territory. The Cabot family, at one time among America’s richest, provided huge grants to Harvard funded in part by profits made opium running into China.

Harvard Management Company, the university’s $35 billion endowment, was an early and enthusiastic LP investor in China as well as large investor in Chinese quoted companies including Sinopec. Their enthusiasm seems to be waning. Harvard Management is apparently considering selling off many of its LP positions, including those in PE and VC funds investing in China.

This looks to be an acknowledgment that the GP/LP model of China investing has not regularly delivered the kind of risk-adjusted cash-on-cash returns sophisticated, diversified institutional investors demand. While China’s economy is doing great, it’s never been harder to achieve a successful private equity or venture capital investment exit. True, the number of Chinese IPOs has ratcheted up this year, but there are still thousands of unexited deals, especially inside upstart Renminbi funds.

While decent returns on committed capital have been scarce, the Chinese government continues to pour billions of Renminbi into establishing new funds in China. There’s hardly a government department, at local, provincial or national level that isn’t now in the fund creation business. Diversification isn’t a priority. Instead, two investment themes all but monopolize the Chinese government’s time and money — one is to stimulate startups and high-tech industry (with a special focus on voguish sectors like Big Data, robotics, artificial intelligence, biotech) the other is to support the country’s major geostrategic initiative, the One Belt One Road policy.

One would need to be visionary, reckless or brave to add one’s own money to this cash tsunami. Never before has so much government money poured into private equity and venture capital, mainly not in search of returns, but to further policy and employment aims. It’s a first in financial history. The distortions are profound. Valuations and deal activity are high, while returns in the aggregate from China investing will likely plummet, from already rather low levels.

Where should a disciplined investor seek opportunity in China? First, as always, one should follow the money — not all the government capital, but the even larger pools of cash being spent by Chinese consumers.

In China, every major consumer market is in play, and growing fast. This plays to the strengths of foreign capital and foreign operating companies. There are almost unlimited opportunities to bring new and better consumer products and services to China. Let the Chinese government focus on investing in China’s future. High-tech companies in China, ones with globally competitive technology, market share and margins are still extraordinarily rare, as are cash gains from investing here.

Meantime, as I reminded the HBS alumni, plenty of foreign companies and investors are doing well today in China’s consumer market. Not just the well-known ones like Apple and Starbucks. Smaller ventures helping Chinese spend money while traveling globally, or obtain better-quality health care and education options, are building defendable, high-margin niches in China. One company started by an HBS alumnus, a native New Yorker like me, is among the leading non-bank small lending companies in China. It provides small loans to small-scale entrepreneurs, mainly in the consumer market. Few in China know much about Zhongan Credit, and fewer still that it’s started and run by a Caucasian American HBS grad. But, it’s among the most impressive success stories of foreign investment in China.

Of course, such success investing in China is far from guaranteed. Consumer markets in China are tricky, fast-changing, and sometimes skewed to disadvantage foreign investors. For over two hundred years, most foreign investors have seen their fond dreams of a big China payday crash on the rocks of Chinese reality.

The rewards from China’s 35 years of remarkable economic growth has mainly — and rightly — gone to the hard-working people of China. But, there’s reason to believe that in the future, more of the new wealth created each year in China will be captured by smart, pragmatic investors from HBS and elsewhere.

 

As published by China Money Network

As published by SuperReturn

YouTube video of the full lecture to Harvard Business School alumni organization